Before you invest in pharma stocks, it’s sensible to figure out what role you want them to play in your portfolio.

As a “non-cyclical” industry, Pharma isn’t hugely affected by the economic cycle. because people need to buy drugs in both the good times and the bad (in contrast to, say, luxury goods). Putting money into the industry might not be a bad idea as a way of shoring up your portfolio during or in anticipation of a recession, then.

Other investors are keen on the sector’s dividends: pharmaceutical firms offer an average dividend yield of 2.27%, which gives them a reliable income alongside any potential gains in stock price. If that’s what you’re after, you might want to compare stocks by comparing their dividend yields, as well as by picking the firm with the healthiest balance sheet. In other words, picking one that has a better ratio of equity to debt, which will make it more resilient during a downturn.

If you’re looking for the company that’ll grow, there are some other things to explore. Look at how many drugs the firm is currently reliant on, when their patents expire, and whether there are promising new treatments in the pipeline. If any of the firm’s drugs are in clinical trials, you can view the results for yourself online to get a sense of whether things are going to plan. It wouldn’t hurt to look at both scientific and pharmaceutical press to see what experts are saying, either.

It’s also pretty easy to compare stocks by their price-to-earnings multiples. At the time of writing, Johnson & Johnson was trading at a price 15.6x higher than its forecast earnings for next year, in line with Merck but higher than Pfizer’s 12.2x. That suggests investors are less confident in Pfizer’s growth potential. If you disagree based on your own research, its stock might look like it’s going cheap.

To know that, you’ll want to get an idea of what a pharma stock is actually worth – and a discounted cash flow model is a good place to start. Our How To Value Stocks Pack goes into more detail, but the discounted cash flow model essentially helps you predict how much money a company will make in the future. Using the risk you’re taking on and the money you could be making elsewhere, you can then figure out how much its stock is worth now.

Of course, forecasting drug firms’ future cash flow is tricky. You might want to break it down by drug, estimating how big the potential market is for each of them and how much the company will be able to sell them for. Then you can add the various estimates together – along with the values of currently available drugs – to predict the whole firm’s future cash flow.

You could even take cash flow models a step further by risk-adjusting them. If, for example, you think Drug X has a 50% chance of making it through trials and bringing in $10 billion, and Drug Y has a 10% chance of making it through trials and bringing in $100 billion, the risk-adjusted value of Drug X is $5 billion, and Drug Y is $10 billion. Adjusting for the likelihood of success in this way helps you make a rational decision about what a potential drug is actually worth.

And if all these numbers have left you with a pounding headache, you could always just invest in the sector as a whole: funds like the Invesco Dynamic Pharmaceuticals ETF and iShares U.S. Pharmaceuticals ETF allow you to diversify your portfolio across a range of pharmaceutical firms.

See, aren’t you starting to feel better already?

In this Pack, you’ve learned:

🔷 The $1.2 trillion pharma industry is non-cyclical – that is, it doesn’t go with the economic tide – which makes it a good way to add resilience to your portfolio.

🔷 The drug development process is expensive and time-consuming – part of the reason drug costs are so high.

🔷 Pharma companies try to reap profits while they have patent exclusivity, because once that expires, prices and profits collapse.

🔷 Miracle cures are on the horizon, which has motivated a spree of acquisitions. But the threat of pricing regulation in the US concerns some investors.

🔷 You can look at P/E multiples to compare pharmaceutical stocks, or you can build a risk-adjusted cash flow model to figure out how much future drugs will be worth.